Tariffs and Trade Wars: Part 3

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Jun 15, 2018 12:55:29 PM

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tariffs and trade warsWe closed part 2 of this series with a summary of the benefits of the current system of open trade: peace, prosperity, and, for the U.S., control of the world system. Although this has come at substantial financial and trade cost to the U.S., this cost has been more than offset by the benefits. Indeed, everyone has won from the current system.

Now, however, times have changed. The policies designed to help countries grow and to keep them in the U.S. orbit have succeeded. You can make the comparison that the U.S. acted as a parent to the global system, picking up the tab for decades. Now, it’s time for the kids to start paying their way. The Bank of Mom and Dad is closed. This is the argument for putting the U.S. first, regardless of the cost to the rest of the world. In many ways, it is an attractive picture—clear and simple. Unfortunately, it is also wrong.

The benefits

First of all, there are real costs for the U.S. in the current system, which are being focused on. But the argument for putting the U.S. first ignores the benefits of that system, which are taken for granted. Let’s look at a few of these.

Reserve currency status. The U.S. dollar is the uncontested reserve currency of the world. Other countries hold trillions of dollars of U.S. assets. You can think of each dollar held by foreigners as an interest-free loan to the U.S. government. This is worth $100 billion per year to the U.S. economy (according to Wikipedia). Financially, that is a big benefit.

Oil market priced in dollars. This is related to the reserve currency status and to U.S. control of global trade routes, discussed below. By pricing oil in dollars, the U.S. is unaffected by exchange rate movements in one of its most important imports. Other countries need to worry not only about the price moves of oil but also about the price moves in their currencies—and they can get hit doubly. We are seeing this in emerging markets right now, which is shaking their economies. The financial benefit of this is hard to quantify but very real.

The U.S. owns the financial system. As the dominant economy and the issuer of the reserve currency, the U.S. has enormous power over the economies of other countries. You can see that in how we can use economic sanctions against North Korea, Russia, and Iran. No other country can do this.

The U.S. owns the trade routes. This is the same argument as above but in real terms. The U.S. Navy owns the oceans. A side effect of providing global security is global control. The U.S. can shut down the economy of any exporting country, such as China, whenever it wants. The Chinese are very aware of this, and the benefit to U.S. diplomacy is real.

Why the existing system works

There are other benefits as well, but these are the most comprehensive. They are very big ones, which cover both economics and security. Since they have been in effect for decades, we tend to take them for granted. They are not immutable, however. In fact, the very factors that make it more expensive for the U.S. to stay open also make it easier for our advantages to erode.

Other countries are richer and can better afford larger militaries. They are more self-confident and more willing to push back against the U.S. Just as the cost to the U.S. increases, the benefits to the rest of the world decline. They can, in fact, revert to their own self-interest when the U.S. does.

They don’t, however, really want to. It is easier and cheaper to let the status quo ride. That is why Europe, for example, has more or less stayed in line with the U.S. and why even China largely works within the existing system, as a partner rather than an opponent. They stay because the system works for them as well.

This is a good thing because as the rest of the world gets richer, their value as partners—and the costs of offsetting them as opponents—rises as well. Whereas before the U.S. stood alone, now we stand as first among partners. Better to cooperate than confront.

The biggest risk

Sacrificing that partnership and turning it into competition or, worse, confrontation is the biggest risk of trying to break the current system entirely. Many countries—China, Russia, and Iran—would love to break U.S. dominance. Breaking the current system would help them do that. We might (might) gain economic benefits. But we would certainly incur economic and security costs, plus lose the benefits of willing cooperation around the world.

There are signs that is already happening. Iran and China are negotiating oil sales denominated in yuan, not dollars. That could spread if other countries take it up—and there is nothing stopping them except allegiance to the U.S.-led world order. With the economic links between the U.S. and Europe at risk, there is renewed determination for countries to go their own way, which might include closer links with Russia. With the links between the U.S. and Asian countries at risk, they have much more incentive to cooperate with China and less incentive to help the U.S. contain its rise. When the U.S. renegotiates its relationship with the rest of the world, we can reasonably expect the rest of the world to take a hard look at how it engages with the U.S. as well.

Strategy versus tactics

This isn’t guaranteed, of course. To recognize the risks is not to ignore the very real changes in the world—or to ignore that changes should, and need to, be made to the current arrangements. As noted earlier, the Trump administration has identified some very real issues that need to be addressed. We can agree on strategy but differ on tactics, and that is what we will talk about next week.

Upcoming Appearances

Tune into Fox Business' Varney & Co. on Friday, September 28, between 8:40 AM and 12:00 PM to hear Brad talk about the markets in-studio with Stuart Varney. Exact interview time will be updated once confirmed. Check your local listings for availability.

Brad will be presenting an Economic and Market Update at the Financial Planning Association’s Annual Conference in Chicago, Illinois, on Thursday, October 4, from 7:30 A.M. – 8:30 A.M. From 10:00 A.M. - 12:00 P.M., he will be signing copies of his new book, Crash-Test Investing, by Commonwealth's booth, #321, in the Exhibit Hall. To attend, visit: https://fpaannual.org/.

 

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